It turns out, this is an old problem surfacing in a new way. In the early 1900's, King Camp Gillette started a new company with a very new business model. Gillette invented the first disposable razor and blade system. Gillette's new system promised customers a sharp shave every time, and promised his company a steady stream of recurring revenue.
Accordingly to legend, he also invented a profit-maximizing business model. He realized he could lower the price of the razors (i.e., selling below cost) to expand his installed base, and he could make his profits with high priced blades. The "Razor and blades business model" was born. Today, successful examples of this model include video games (low priced game consoles, high priced games), printers (low priced printers, high priced ink), and pod-based coffee systems like Nespresso and Keurig.
Or, that's how the legend goes. The truth is more complicated — and more instructive. Gillette patented his new technology, giving him a monopoly on the market. He also positioned the Gillette razor blade as a luxury product. At launch, Gillette's disposable razors cost five times more than the average fixed razor.
Gillette made his initial fortune with high priced razors and high priced blades. Today, we see many examples of this approach, the most famous being Apple. Apple makes a lot of money from secondary products (App Store fees, various service subscriptions), but does not need to lower device prices to expand its installed based. Similarly, Peloton's hardware products have a premium price.
Gillette's patents expired in the 1920's. At this time, cheap razors flooded the market. Gillette knew that cheap razors might tempt his loyal customers to switch to a new system, so he dropped the price of his razors to maintain market share. He also invented and patented a fancy new razor available at a more premium price for more upmarket customers. Gillette follows this same strategy today, with some joking about how far they'll go.
Phew, that was a lot of history. Let's get back to your question: What are the points to consider when pricing connected smart products?
A connected smart product is similar to a "razor and blade" system. You have an initial purchase, the connected hardware (i.e., the razor) and secondary purchases in the form of a cloud subscription (i.e., the blades).
The Gillette case illustrates three fundamental elements to this type of pricing strategy:
1. Pricing power at initial purchase2. Attach rate on the secondary purchases3. Switching costs to a new system
The price of the initial purchase can vary a lot — from a premium price for a highly demanded product to entirely free giveaways. For example, the personal training service Future, loaned new users Apple Watches in the early days of growing their subscriber base. Some companies have gone as far as to pay people to join their system.
There are two problems to solve. The first is that you want to capture as much demand as possible. In industries with "razor and blade" business models, market share is often "captive" (i.e, its difficult for people to switch into a new system). For this reason, capturing market share is key to having a defensible position.
The second is that you want to capture as much revenue as possible, but you can only do this if demand for the product is high. Apple can simultaneously command high prices for their devices and capture significant market share. On the other hand, Amazon needed to offer its Alexa devices at a low price in order to create and capture the smart home market.
Notably, pricing power often changes over the lifecycle of a system. In Gillette's case, they lost pricing power when patents expired. They solved this by launching a new system with patented technology while growing their established system. In other cases, pricing power can increase as market share increases and more people get locked into the system. This has happened with Apple devices.
So, the key question to ask is: What price should we set to maximize market share growth and capture the most value?
The "razor and blade" business model derives most of its value from providing customers with supplies once they are part of the system: blades, video games, ink, and cloud services. This revenue is generated because customers are "attached" to the system (hence the term, attach rate).
The attach rate is important because it is the major driver of lifetime value (LTV). Companies should consider the entire lifetime value when making strategic decisions. For example, companies often borrow from future revenue to subsidize the price of the initial purchase (allowing them to capture more market share). This is the reason people got used to paying almost nothing for $1,000 smart phones.
It is critical that companies understand the current attach rate and future optimizations to attach rate. A miscalculation on attach rate can be financially devastating, and small improvements to attach rate can lead to long term competitive advantages.
So, the key question to ask is: How much revenue will we make from secondary purchases and what effect should that have on our initial purchase price?
Companies with a "razor and blade" business model may not have a lot of pricing power at the initial purchase, but often have considerable pricing power once a customer has adopted the system. This explains the high price of printer inks which cost very little to produce.
However, companies do not have infinite pricing power. If the recurring costs become too great, customers may churn or switch to a new system.
The key factor here are the "switching costs". Theoretically, each time a person purchases a secondary product, like your cloud service, they'll do a quick gut check: is it worth it to stick with this system, or should I switch to something else?
There are some hard costs of switching to a new system (like buying a new razor or a new connected device). In addition, customers face "soft costs" like the inconvenience of making the switch and the uncertainty of whether the new system will meet their needs. It turns out that these soft costs often outweigh the hard costs.
Our friend, King Gillette, made a fortune based on that insight. When his patents expired, conventional wisdom suggested that he should lower prices on both razors and blades.
The presence of low cost, imitation blades should cause people to switch if blade prices are too high. Instead, Gillette realized that people would be reluctant to use a cheap, imitation blade once they were bought into the Gillette system. So, he lowered the price of razors (to compete with the flood of cheap razors based on his expired patents), but kept the cost of blades high.
Pricing individual products is hard -- it's more of an art than a science. Companies must take into account a variety of factors including competition, elasticity of demand, and mental framing.
That challenge becomes even harder for something like a connected smart product which involves both an initial purchase and a recurring subscription.
The "razor and blade" business model provides the insight we need to understand the relationship between the initial purchase and the secondary purchases -- thereby unlocking the most valuable pricing strategy.
To summarize, we need to understand pricing power at the initial purchase, maximize the attach rate for secondary purchases, and create a system with high switching costs (including both hard costs and soft "psychological" costs).
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